Who will lead the Fed?

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Ben Bernanke's term as Chairman of the US Federal Reserve finishes in January next year, and President Obama has indicated that he will be replaced rather than reappointed.

The past few years demonstrate that running a central bank has plenty of pitfalls, with the 2008 crisis identifying mistakes and setting challenges to restore economic normalcy. On history's current judgment, Bernanke is looking like the right man for his times, while Greenspan has emphatically lost his 'Maestro' status. In the UK, Mervyn King ignored financial stability problems and has been succeeded by a Canadian. At the European Central Bank Jean-Claude Trichet is judged to have been too narrowly focused on inflation and prepared to risk euro collapse rather than put the ECB balance sheet at risk. With so much at stake, this is not a trivial appointment.

What skills will the next head of the Fed require? The technical aspects don't seem too hard. The Fed's version of flexible inflation targeting is still valid (with one eye on output and unemployment), though financial stability needs more attention than it got before the 2008 crisis.

The real challenges are more subtle. The new Chair must carry the authority to lead a board not short of egos or strongly-held views, steering a collegiate course between Greenspan's idea-stifling dominance and a free-for-all cacophony of disparate voices. Preserving the Fed's independence requires a respectful but not obsequious relationship with the president and fancy footwork in front of congress. Moreover, the Chair has to command the respect of financial markets and the confidence of the public. Effective monetary policy depends on creating the belief that the Fed will do all that is necessary to ensure a smoothly running economy. Tending inflation expectations and 'animal spirits' is the key.

So how do the two front-runners rate?

Janet Yellen (pictured) hasn't put a foot wrong as Fed Vice-Chair for the past three years, and her central bank experience goes back a long way. She would provide continuity; she knows the ropes and is familiar with the other members of the Fed Board. Passing her up would be widely read as an unfortunate signal on the role of women. She is seen as a monetary policy 'dove', which is a plus for those concerned about the continuing weakness of the economy.

The other front-runner is Larry Summers. His economic beliefs are much the same as Yellen's. He has a close relationship with the President, prodigious energy and off-the-scale intelligence. He also comes with an unhelpful track record. Insensitive comments about the role of women in science when he was Harvard president are still remembered. Close connections with Wall St (including an ongoing consultancy role with Citibank) raise issues of bias and undue influence. He was an outspoken and dogmatic advocate for deregulation: giving Wall Street free rein on derivatives no longer seems like such a great idea. He, along with Greenspan and Rubin, was featured in the absurd 'Committee to Save the World' cover of TIME magazine during the Asian crisis.

He has, however, one other thing going for him. The main challenge for the Fed in the short term is unwinding quantitative easing (QE). Financial markets have become addicted, forcing the Fed to keep the flow of bond purchases going, using their usual blackmail tactic of warning about imminent market collapse unless the Fed does the market's bidding.

Yellen will be an easy target for this ploy, as she is on record as being a believer in the immense power of QE. It will be hard for her to unwind QE in a still-weak economy, so it is more likely to be kept going too long.

Summers, on the other hand, has been a quiet sceptic. This gives him the opportunity to wind QE down in two stages. First, he has to gently persuade financial markets that QE wasn't all that important anyway. Second, he has to then wind it back. QE's potency was all in the mind, so the unwinding is mainly about market psychology.

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